On the Wave of a New Industry

C PA David Bass has entered a fast-growing industry that is well suited to an accountants training and abilities, the field of professional employer organizations (PEOs). PEOs work mainly with smaller companies, taking on the administrative burdens of employment for them. According to the National Association of Professional Employer Organizations (NAPEO), the industrys growth in gross revenues was roughly 35% in each of the last three years, and PEOs serve as employers of record for between 2.5 million and 3 million workers.

Building A PEO

Bass, a former audit manager at Arthur Andersen LLP, left the large firm in 1991 to become CFO of U.S. Personnel, a temporary staffing company, joining with a small equity stake. At that time, company revenues were growing from 40% to 60% per year. The company formed a PEO in 1994 and then sold everything but the PEO to a larger temporary staffing company in 1996. The staffing portion of the business hadnt actually been for sale, Bass says, but it was worth more to them to buy it than it was for us to keep it.

Bass teamed with one of U.S. Personnels founders and a third partner to recapitalize the PEO and run it as Paradyme Corp., an independent business. The company now has 550 clients, about 10,000 worksite employees and close to 100 internal employees. According to NAPEO, there are roughly 1,800 to 2,200 PEOs across the country, and 15 states have licensing or regulations for these businesses. NAPEO Vice-President Milan Yager says PEOs need the skills of accountants, actuaries, risk managers, attorneys and benefits and human resource experts. He reports that the founders of most of these organizations are lawyers, human resource professionalsor CPAs. Because strong internal controls and understanding of compliance issues are crucial to the businesses, Bass believes CPAs are ideally suited for them. Not only does he frequently run into CPAs at industry conferences but CPAs also owned two of the five PEOs that Paradyme has acquired since its inception.

What They Do

Paradymes typical client has between 10 and 100 employees, with an average of 20, although the company does work with businesses that have as many as 850 workers. The average client has no human resources personnel. Instead, the business owner does the payroll work at night or on weekends, Bass says. Most small clients have no employee handbook, no definitive statement of company policy on many important matters such as vacation, substance abuse, sexual harassment or progressive discipline. There is no formal safety program. When someone is injured, Bass says, the owner turns the claim over to the insurance carrier and assumes the carrier will handle it in the right way, which often doesnt happen. You can have a dramatic impact on the ultimate cost of workers compensation claims by implementing a very proactive and disciplined system for dealing with them.

In addition, at many small companies, once a year the business owners feel totally tormented by their health insurance and other employee benefits renewal choices. I met with someone who owns a wholesale distributor of floor coverings with 135 employees. He could talk all day long about the different grades of carpet, but when we started discussing health insurance, he looked sick. He said, I hate this. I wish we could go to the doctor and take a couple of chickens and a dozen eggs, or some vegetables from the garden, and pay that way. I dont understand networks, acronyms, referrals, getting approvals. The insurance companies send me explanations that dont explain anything.

Heres how a typical arrangement with a PEO might work. A small business owner begins to feel overwhelmed by the administrative demands of being an employer. He contracts with a PEO to take over these duties. He retains the same workers, and the right to hire and fire employees, but the paperwork and risk- and cost-management aspects of employing the existing permanent workforce are transferred to the PEO.

According to Bass, PEOs offer four main services to clients:

1. Payroll. The PEO becomes the legal employer of record for payroll purposes, shouldering all the withholding responsibilities, including not only taxes but also garnishments, court orders and child support. With garnishments, it can be very difficult to figure out how much to deduct, Bass says, especially for small business owners with no experience in this area. For example, an order might decree that if the employee makes more than $200 per week, the employer should deduct $30, but if the wage is less than $200, only $20 should be deducted. When numerous employees are affected, we have to develop a computer algorithm to handle that and then make sure the right amount is sent to the right place at the right time, Bass says.
2. All employee benefits, including insurance, pension and others. At Paradyme, we take all of our worksite employees and pool them together for benefits purposes, Bass says. The company offers clients four different health insurance plans to choose from, some of them exclusive to a particular state, plus dental, life and disability insurance, a flexible 401(k) plan and a variety of supplemental benefits through a cafeteria plan. This duty lends itself well to what CPAs do, which is to keep up with regulations and ensure compliance.
3. Workers compensation. We sponsor a policy that covers all our worksite employees, Bass says. Our risk management department ensures that each client worksite has a safe work environment and helps injured workers get back to work at full pay as quickly as possible. The employees are protected on both ends.
4. Human resource management. This broad category includes making sure client policies comply with labor laws, such as the Fair Labor Standards Act, the Family and Medical Leave Act and the Americans With Disabilities Act. In addition, we take proactive steps, such as supplying employee handbooks, performance appraisals, hiring and termination procedures and substance abuse policies for clients, Bass says.

Companies that contract with PEOs come from a wide range of industries. Paradyme clients, for example, include light manufacturing, retail, restaurants, building trades and professional practices. When working with medical practices, the physicians are our employees for payroll and benefit purposes. Because of the risk it assumes as employer, Paradyme avoids areas such as high-rise construction and roofing. There are safety issues that are difficult to feel comfortable about without having our own representative on site all the time, Bass says. At most clients, the company liaison to the PEO is the company owner, but no Paradyme staff member works on site. We are very safety conscious. Other companies in our industry love high-risk clientssome specialize in them. Among the other specialists is a PEO in California that executes paperless transactions with its exclusively high-tech clients, Bass reports.

Although PEOs dont directly supervise or select employees, Basss company does get involved in the final phases of the hiring process. Were assuming the risk and responsibility of being the employer. If the client hires someone to work in the accounting department, we want a credit background check. If someone is going to be driving a vehicle, we want a drug screen and a motor vehicle bureau check. If a new hire will be doing heavy lifting in a warehouse, we want a physical exam. We check prior employment references. We make sure new employees sign a consent to be screened for drugs in case of an accident or injury. We determine whether they have an unusually high risk of filing a workers compensation claim. If we are going to claim status as an employer, we have to act like one. Were not just an agent.

Because direct supervision remains with the client company, PEOs rely on the concept of coemployment, which Bass says has its roots in English common law. We refer to the client as the worksite employer and to ourselves as the administrative employer. We have a written agreement that spells out who is employer of record for different items. Clients retain day-to-day operational control, deciding what workers do, how they do it and what tools they use. They also decide work hours, rates of pay and performance expectations. Most people know very well how to run their own businesses, Bass says. When it comes to reconciling 401(k) deductions to W-2 forms, however, thats a mystery.

Strong Controls

The need for strong internal controls is one reason CPAs are well-suited to PEOs. The margin is very thin, Bass explains. A lot of what we bill the client is direct wage cost, while the portion of the invoice that represents our profit is relatively small. Paradyme sends invoices every pay period. We allow clients the flexibility to set their pay cycles, so their schedules drive our internal control requirements.

Other issues further complicate the heavy administrative burden that PEOs bear. The compliance aspect of qualified benefit plans is one example. Multistate employers are another, because they require reconciliation of tax requirements in multiple jurisdictions. State unemployment taxes are an experience-based tax, so once a year the rate used must be recalculated from the rate for the previous year. Managing that cost can play a significant factor in a PEOs responsibility. The PEO also must have staff familiar with reporting requirements in different states who can reconcile various payroll reports for each state to meet deadlines.

The PEO also works with the client to reduce unemployment claims, which can drain the reserve fund the employer pays into the state, Bass notes. Its a complicated equation, he says. The more taxes accumulated by any employerand not paid out to laid-off employeesthe lower the tax rate for that employer.

Since Paradyme has the status of one large employer encompassing many different companies, it sometimes can find a position with one of its clients for an employee laid off by another client. If the employee was discharged for cause, the PEO works with the client to ensure the proper documentation is in place. Over time, this kind of management can have a dramatic impact on our cost structure. We need strong operational controls to deal with the claims side and financial controls to deal with the tax side.

In an ideal world, Bass says, your payroll system interfaces directly with accounts payable so, for example, the deduction you take from an employees check automatically goes where it should. Most small companies dont have this capability. Paradyme has been able to automate most of its responsibilities, but a large amount of reconciliation still is required. For example, some clients will pay 75% of an employees health insurance but none of a dependents insurance. Paradyme has two sources of recoverythe employee, who pays for his or her own insurance plus any dependents, and the clientand one invoice to pay for the insurance company.

With new employees added and deleted from benefits coverage daily, there is also the waiting period before coverage begins to consider. Because of the constant reconciliation process, we truly need strong controls to ensure that its working properly and not under- or overbilling clients or employees.

No individual part of it is rocket science, Bass says, but there are a whole lot of details. To handle them the company has a 10-person accounting department and a 20-person payroll area. Another 20 work in human resources and benefits. The payroll department is really the operation; its the client service function. Payroll staff members take information from the client and process it to generate the payroll and the invoice, plus they interface with accounting and benefits on taxes and other deductions. The risk management department has a staff of seven, and there is one attorney on staff who often consults with outside counsel on labor law issues.

Size Counts

In its brief history, Paradyme has expanded from overseeing fewer than 300 worksite employees to about 10,000 today. Bass advises CPAs interested in this burgeoning industry to be prepared to structure a strong control environment.

In addition, he counsels that size counts. Paradyme bought five other PEOs in recent years in part because a larger employer has much greater purchasing power in buying workers compensation insurance, employee benefits or retirement plans. We felt there was a certain critical mass we should try to attain as quickly as we could. Larger operations also helped support the departmental structure that PEOs required. Some of the smaller companies weve acquired had reached a point where they had a handful of generalists going in a lot of different directions at one time. They had reached their capacity. For entrepreneurs interested in this industry, he suggests they be ready to expand quickly to reach the most efficient size.

To be successful, Bass says, you have to know a lot of things about a lot of things. My career at Arthur Andersen was a great training ground because I learned to research technical issues thoroughly and the importance of having all the facts. New PEOs should focus on one or two states and get involved in NAPEO before branching out too far. NAPEO is a wonderful resource for PEO owners to understand fully the implications of being a coemployer and the many regulations or laws that vary from state to state.